There are several well-recognized situations in which an investor may own, or be “long” in, a substantial, highly valued quantity of a single stock, also known as a concentrated equity position, yet be unable or unwilling to sell that stock for a lengthy period of time.
Investors may develop a concentrated equity position, for example, through the long-term bullish performance of an investment. The position may be acquired through an inheritance or the receipt of a gift of a large quantity of a single stock. Employees may come into the position through the receipt of appreciating stock options or through a merger or acquisition event where there is a stock-for-stock payout.
A concentrated equity position may be illiquid, for example, because the stock is unregistered or its sale is regulated or contractually restricted. Tax liabilities may discourage a stock sale.
An investor in a concentrated, illiquid equity position runs the substantial risk that the value of the stock will diminish before his position becomes liquid. If the value of the stock drops before an investor is able or willing to sell the stock, a substantial amount of money may be lost. Hedging strategies based on the sales and/or purchases of stock derivatives are a recognized way of minimizing the risk associated with an illiquid stock position. A purchased, or “long”, put option minimizes an investor's downside risk by providing a floor, or put “strike price”, at which the investor may sell the stock until the put option's “expiration date”. Combined with a long stock position, the purchase of a put option limits an investor's downside risk per share to the put strike price less the put option cost.
Call options are another common stock derivative providing the right to buy a stock (for the buyer of the option) or the obligation to sell a stock (for the seller of the option) at a call strike price through an expiration date. While the purchase of call options is a common strategy for investors, what is of particular interest with respect to the present invention is the sale of a call option by the hypothetical, illiquid investor described above. When an investor owns the underlying stock for which the call option is being sold, the call option is said to be “covered.” Covered call options minimize the option seller's downside risk because the owned stock can be liquidated to cover the exercise of the call option by the buyer. Alternatively, the call option may be covered with cash. Covered call options, however, limit the call option seller's upside. If, in fact, the value of the underlying stock rises, the call option seller is obligated to sell the stock to the call option buyer, on or before the call option expiration date, at the call strike price.
Revisiting again the situation of the concentrated equity, illiquid investor, this investor may desire to purchase put options in order to minimize the downside risk during the period that the stock is not liquid. However, exchange-listed put options are both expensive and also relatively short in duration. Exchange-listed put options, as traded on the open market, have expiration dates no longer than about six months forward of the purchase date. The further out the expiration date, the more expensive the put options become. Customized, long-term put options are available at substantial cost to hedge concentrated, long-term equity positions. They are, however, prohibitively expensive. They are also generally only available to high-net-worth individuals hedging a substantial quantity of stock.
One way of paying the cost of a put option is to simultaneously sell a call option, in this case a covered call option as described above. This hedge strategy, simultaneously purchasing a put option while selling a covered call option, is termed a “collar.” It will be understood that the put options in a collared option position limits the downside risk to the equity holder, while the cost of the put option may be covered through the sale of the call option. Generally, for the same time periods, the income from a call option at 1.48 times the current underlying stock price equals the cost of a put option. at 0.95 times the current underlying stock price.
It will be understood that, just as a put option limits the downside of an underlying stock position to the strike price of the put option, the sale of or obligation of a call option limits the upside of the underlying stock position to the strike price of the call option. The stock, or equivalent cash, must be delivered by the seller of a call option if the actual stock price exceeds the call option strike price before the call option expiration date. This is, however, an acceptable risk to an investor holding an illiquid, concentrated equity position. Such an investor is typically more concerned with losing real current value than surrendering any potential increase in value.
Given an understanding of a collared option hedge strategy, the hedge position is difficult if not impossible to purchase for a high-value, high-concentration equity position as a standard product. Due to the typical long-term position of the high-value, concentrated equity holder, collars for such investors are typically available only as special-purpose products through financial service firms. It will be appreciated that, given the right pricing model, a collared option hedge position can be a profitable product for a seller. However, such products require a substantial amount of labor to both create and to manage for profit. It will be understood that, given the right pricing structure and active management of a bank's position in the hedged stock, a collared option product can be a profitable financial product for a bank. In fact, many banks offer such products. However, the set-up and management of such products is complex and expensive.
Because of the complex nature of creating and managing a collared option hedge product, sellers of this type of product will only sell them to concentrated equity investors holding a very high value of stock. Further, because of the risk that the investor may have to pay cash to cover a call option should the underlying stock continue to be illiquid for an extended period of time, such products are typically only available to high-net-worth individuals.
Accordingly, it would be desirable to provide a collared option hedge product that is more affordable to and readily available to investors than those products currently available today.
With the prolific spread of retail trading systems and the long-term bullish outlook of the market, there are many more investors today than have existed in the past. For example, stock options have become a standard form of employee compensation, making many more high-concentration equity investors than have been typical in the past. Affordable, available stock trading systems have increased the ‘ordinary’ family's investment in the market, increasing the likelihood of concentrated equity positions to those who may not have even traded stocks some decades ago. In the ‘new’ investment environment, a smaller concentrated equity position may still constitute a substantial quantity of the wealth of the owner.
Under the current state of the business, collared option hedge products are generally too expensive or otherwise not available to these ‘new’ investors. The present inventors have determined that making collared option hedge products more available would be beneficial to the investors and could be done in a manner profitable to the provider of the products themselves.